DOWNPLAYING CONTINGENCIES
A second way to mold disclosure to suit the issuer’s interests is by downplaying extremely significant contingent liabilities. Thanks to the advent of class action suits, the entire net worth of even a multi-billion-dollar corporation may be at risk in litigation involving environmental hazards or product liability.
Understandably, an issuer of financial statements would prefer that securities analysts focus their attention elsewhere.At one time, analysts tended to shunt aside claims that ostensibly threatened major corporations with bankruptcy. They observed that massive lawsuits were often settled for small fractions of the original claims. Furthermore, the outcome of a lawsuit often hinged on facts that emerged only when the case finally came to trial (which by definition never happened if the suit was settled out of court). Considering also the susceptibility of juries to emotional appeals, securities analysts of bygone days found it extremely difficult to incorporate legal risks into earnings forecasts that relied primarily on micro- and macroeconomic variables. At most, a contingency that had the potential of wiping out a corporation’s equity became a qualitative factor in determining the multiple assigned to a company’s earnings.
Manville Corporation’s 1982 bankruptcy marked a watershed in the way analysts have viewed legal contingencies. To their credit, specialists in the building-products sector had been asking detailed questions about Manville’s exposure to asbestos-related personal injury suits for a long time before the company filed. Many investors nevertheless seemed to regard the corporation’s August 26, 1982, filing under Chapter 11 of the Bankruptcy Code as a sudden calamity.
Manville’s stock plunged by 35% on the day following its filing.In part, the surprise element was a function of disclosure. The corporation’s last quarterly report to the Securities and Exchange Commission prior to its bankruptcy had implied a total cost of settling asbestos-related claims of about $350 million. That was less than half of Manville’s $830 million of shareholders’ equity. On August 26, by contrast, Manville estimated the potential damages at no less than $2 billion.
For analysts of financial statements, the Manville episode demonstrated the plausibility of a scenario previously thought inconceivable. A bankruptcy at an otherwise financially sound company, brought on solely by legal claims, had become a nightmarish reality. Intensifying the shock was that the problem had lain dormant for many years. Manville’s bankruptcy resulted from claims for diseases contracted decades earlier through contact with the company’s products. The long-tailed nature of asbestos liabilities was underscored by a series of bankruptcy filings over succeeding years. Prominent examples, each involving a billion dollars or more of assets, included Walter Industries (1989), National Gypsum (1990), USG Corporation (1993 and again in 2001), Owens Corning (2000), and Armstrong World Industries (2000).
Bankruptcies connected with asbestos exposure, silicone gel breast implants, and assorted environmental hazards (see Chapter 13) have heightened analysts’ awareness of legal risks. Even so, analysts still miss the forest for the trees in some instances, concentrating on the minutiae of financial ratios of corporations facing similarly large contingent liabilities. They can still be lulled by companies’ matter-of-fact responses to questions about the gigantic claims asserted against them.
Thinking about it from the issuer’s standpoint, one can imagine several reasons why the investor-relations officer’s account of a major legal contingency is likely to be considerably less dire than the economic reality.
To begin with, the corporation’s managers have a clear interest in downplaying risks that threaten the value of their stock and options. Furthermore, as parties to a highly contentious lawsuit, the executives find themselves in a conflict. It would be difficult for them to testify persuasively in their company’s defense while simultaneously acknowledging to investors that the plaintiffs’ claims have merit and might, in fact, prevail. (Indeed, any such public admission could compromise the corporation’s case. Candid disclosure therefore may not be a viable option.) Finally, it would hardly represent aberrant behavior if, on a subconscious level, management were to deny the real possibility of a company-wrecking judgment. It must be psychologically very difficult for managers to acknowledge that their company may go bust for reasons seemingly outside their control. Filing for bankruptcy may prove to be the only course available to the corporation, notwithstanding an excellent record of earnings growth and a conservative balance sheet.For all these reasons, analysts must take particular care to rely on their independent judgment when a potentially devastating contingent liability looms larger than their conscientiously calculated financial ratios. It is not a matter of sitting in judgment on management’s honor and forthrightness. If corporate executives remain in denial about the magnitude of the problem, they are not deliberately misleading analysts by presenting an overly optimistic picture. Moreover, the managers may not provide a reliable assessment even if they soberly face the facts. In all likelihood, they have never worked for a company with a comparable problem. They consequently have little basis for estimating the likelihood that the worst-case scenario will be fulfilled. Analysts who have seen other corporations in similar predicaments have more perspective on the matter, as well as greater objectivity. Instead of relying entirely on the company’s periodic updates on a huge class action suit, analysts should also speak to representatives of the plaintiffs’ side. Their views, while by no means unbiased, will expose logical weaknesses in management’s assertions that the liability claims will never stand up in court.